To make money in stocks, follow the big money

JonMarkman

SEATTLE (MarketWatch) — Higher gasoline prices, Japan supply-chain disruptions and fear of the Fed were supposed to bury corporate results and investors in red ink this earnings season, but it hasn’t exactly turned out that way. Through Monday, more than 70% of companies that have reported results crushed quarterly estimates by an average of 8.8%.

Yet the gains have not been evenly distributed, as some large companies including Google Inc.
GOOG, +0.81%
and Alcoa Inc.
AA, -1.08%
have seen shares blasted by more than 10% despite decent results, while more obscure, medium-sized companies like grocery chain Supervalu Inc.
SVU, +0.14%
and industrial manufacturer Gardner Denver Machinery Inc.
GDI, +0.16%
have gone on a tear.

Why the difference? To answer that burning question, I spoke to Craig Drill, a veteran hedge-fund manager in New York who has been around the block so many times that he not only knows where the bodies are buried — he also spaded dirt on a few himself. When Drill speaks, which he does not do in public much, you need to pay attention.

Drill says that before you can understand which stocks are likely to advance the most in this cycle, you need to understand who the big buyers are. He observes that people running money at the large funds who drive the market today are survivors of a lost decade; they’ve watched colleagues who made mistakes dumped on the side of the road and left to bid for jobs as peanut vendors at baseball games.

Stocks on the block

Today’s fund managers aren’t going to risk their careers on companies with big names but erratic results. And they do not have time to seek out new ideas and try a small position in unknowns. They are so far behind in their bogeys after 10 years in the wilderness, they are sticking with proven winners that won’t embarrass them, and everything else be damned.

Drill noted that the economy is fitfully gaining traction, credit markets are open enough for companies to borrow for responsible projects, government bonds provide no competition for investment dollars, and real estate is plagued with overcapacity.

Accordingly, the door is wide open, he said, for expansion of the price/earnings multiple of the entire U.S. market over the next few years to at least 17x from 13x at present.

That should combine with improved corporate earnings growth to provide annual returns for equities in the high teens for two or three more years — unless the Fed messes up and constricts credit.

Just so you know what that implies, consider that the Standard & Poor’s 500 Index
SPX, -0.55%
started this year at 1,260. A return of 18% would put it at 1,485, which is about 80 points below the record set in 2007. Another 18% year after that would put the benchmark index at 1,753. These are not outrageous goals.

Drill said he believes equities will be the main game in town even if GDP growth slows to around 2% to 3% a year amid a transition from robust recovery to moderate expansion. And not just any equities, but the high-growth attention getters that always seem too expensive.

“With the battered and embarrassed institutional investors only glacially increasing their equity exposures and reluctant retail investors returning slowly to stocks, the more aggressive, absolute-performance-driven hedge funds will set the direction, speed and tenor of the market,” he said. “The tail will wag the dog.”

To maximize returns, Drill says, funds will gravitate to investments that can demonstrate consistent, top-line “organic’’ revenue growth well in excess of their competitors. He forecasts that above-average earnings growth will lead to ever-rising P/Es at favored companies. In contrast, earnings growth that is achieved by mergers, share buybacks, cost cutting, and financial engineering — hello Google, we’re talking about you — will not be rewarded with higher valuations.

Drill’s bottom line: “Investors will favor those countries, sectors, industries, and companies demonstrating the most rapid organic growth. They will become the new global market leaders.”

The ‘Nifty 250’

The fund manager argues that this coming phenomenon will be a hybrid of the “Nifty Fifty’’ market of the early 1970s. Back then, big institutional investors orchestrated a bubble in the stocks of a narrow list of large capitalization, one decision (buy), “perpetual growth’’ companies, such as the now-disappeared Polaroid, Kresge and MGIC.

The lowest valuation at 21x was held by First National City Corp., while Disney commanded the highest at 71x, Drill recalled. That group of 50 stocks averaged 42x earnings versus 19x for the S&P 500. This speculative excess had a predictable collapse with a devastating two-year-long bear market that lasted until December 1974.

Drill argues that today’s growth-stock bull market, while narrow, will be far more democratic than its predecessor. The earlier version was promulgated by the domestic money-center bank trust departments whose asset allocation models were extremely limited in scope — focused on domestic big-caps only. Today, the breadth of investment options available to hedge funds is vast. Hence he thinks that buying will broaden out a tad to all global exchanges and all capitalization sizes.

He calls this bigger group the “Nifty 250.” And what is important to keep in mind is that this two-tiered market “will be the bane of most investors,” he said.

Here’s why: Value managers will be constantly ensnared in value traps, while managers who specialize in “growth at a reasonable price,” or GARP, will be challenged to find reasonable prices. Meanwhile, valuation-based short sellers will be severely squeezed, and pair traders will caught holding inverted positions.

A cadre of disciplined, steadfast, momentum players will wag the dog, Drill forecasts.

Of course the excesses stemming from this bifurcated market will provide the fodder for the next bear market. But since we are just embarking on this journey, that risk should not be your main concern, Drill noted. Being left behind is a much deeper concern to money managers who seek job security than worries about being left holding the bag.

Big on midcap growth

So what does this mean on a more practical level? It suggests that the fastest growing medium-sized companies are going to continue to be the leaders that they have been over the past 16 months.

These stocks, embodied in the fund iShares S&P Midcap 400 Growth
IJK, -0.01%
, have beaten their size and style rivals — from small-cap value to large-cap growth — at every turn both this year and last, with shallower declines and faster advances out of troughs. IJK was also the size-style winner in 2010, rising 30.4%, vs. 26% for small caps and 12.8% for the S&P 500.

Example? Gardner Denver is one of those mid-cap growth stocks that I admire. Shares have risen 325% in the past two years to the point where it rocks a $4.9 billion market cap.

In its quarterly report last week, Gardner Denver reported earnings per share rose 85% in the first quarter over the first quarter of 2010 on a 26% increase in revenue. Its backlog of business also rose 47% from the same quarter in 2010, and executives raised the outlook for the rest of the calendar year.

In the context of Drill’s comments, check out the earnings-day comment of Gardner Denver Chief Executive Barry Pennypacker: “I am very pleased with the record-breaking financial results achieved by the company in the first quarter, reflecting strong organic growth in our end markets.”

“Organic” growth is key. He is saying that Gardner Denver achieved the results not through acquisitions, or financial engineering, or share buybacks, but by creating and selling products.

Apple Inc.
AAPL, -0.45%
is the same kind of company in that it has achieved its incredible growth through home-grown innovation and smart marketing, not by buying competitors and bolting on their growth. This is important because such growth is sustainable, and executives are not constantly distracted by flirting with and courting other companies and then forcing these war brides into their corporate culture.

Compare this approach with the mess that Google Inc. and Cisco Systems Inc.
CSCO, -1.70%
have created for their long-suffering shareholders by constantly blowing money on bad acquisitions in their unsuccessful pursuit of growth at any cost.

So as we motor forward over the rest of this year, keep the concept of the Nifty 250 in mind. If investors will pay up for reliable fast growers, and shun everything else, then by the end of the cycle we will have one small group of very expensive stocks and one large group of cheap stocks. A bear market will ensue by, say, 2016, and the two groups will trade places in investors’ affections. Rinse and repeat.

Jon Markman is a MarketWatch columnist. He runs a money-management and investment-advisory firm in Seattle. For more ideas like these, try a two-week trial to Markman’s daily investment newsletter, Strategic Advantage, published in partnership with MarketWatch, his daily trading newsletter, Trader’s Advantage, or his futures letter, Gemini 252. Follow Markman on Twitter @jdmarkman.

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